BFF5300- Case Studies in Finance

Semester 2, 2019

Week 2: Case 1

Betting on Failure: Profiting from Defaults on Subprime Mortgages

Group Members:

Student’s name Student’s ID Comments

MD IMRAN HOSSAIN 28228073

POON KA SHING 26076195

SHIVANTA DA SILVA 26442523

Date of Submission: August 8, 2019

Page | 1
 Table of Contents

1. Introduction...............................................................................................................................3
2. Anthony Keating and his investment challenge.......................................................................3
3. Securitization of home mortgages............................................................................................4
4. Subprime mortgage and the Global Financial Crisis (GFC)....................................................4
5. Credit Default Swap (CDS) and its usage................................................................................5
5.1 A real-world example of CDS speculation in Greek crisis.................................................6
6. Risks and Rewards of CDS trade..............................................................................................6
7. Quantitative modelling for estimating Keating’s profits from the CDS trade on MBS...........7
8. Recommendation and Conclusion............................................................................................7
References.....................................................................................................................................8
Appendices...................................................................................................................................9
Appendix-1: The securitization process of MBS......................................................................9
Appendix-2: Quantitative modelling for estimating Keating’s profits from the CDS trade...10

Page | 2
1. Introduction
This report analyses the particulars of an investment decision regarding Credit Default Swap
(CDS) trade on Mortgage Backed Securities (MBS) by Anthony Keating. We have discussed
the investment challenges Keating is facing in section 2, securitisation process of home
mortgages in section 3 and the linkage of subprime mortgage with global financial crisis in
section 4. The usages of CDS and the potential risks and rewards of CDS trade are explained in
section 5 and 6 respectively. In addition to the prescribed requirements of the case, we have
also developed a quantitative modelling for estimating Keating’s profits on the CDS trade in
section 7. Finally, section 8 concludes with our recommendation.

2. Anthony Keating and his investment challenge

Anthony Keating is an investment manager at BB&M, a private bank in Boston. His path to
becoming a successful investment manager was unconventional, with completing his doctorate
in meteorology. Being expert in mathematical models, Keating built a reputation within a short
span of career because of his innovative and unorthodox investment strategies that generated
substantial returns for his clients. For instance, Keating generated an astounding 750% return
by buying put options on airline stocks, solely based on his personal experience that he
encountered on his journey from Las Vegas to Boston.

Keating is currently facing several investment challenges. First, not being able to do what he
typically does best (i.e., generating higher returns for his clients) due to the ongoing financial
crisis and bearish equity market, Keating is considering to shift his investment strategy from
equity market to housing market by following a giant hedge fund Paulson and Co. that
generated more than $15 billion by buying CDS protection on subprime MBS. However,
Keating had to do something different from Paulson’s strategy because it was too late to follow
the same strategy to make profits. Second, Keating is not acquainted with new financial
instruments used in housing markets (e.g., CDS and MBS). So, through extensive research, he
had to promptly familiarise himself with their complex features to understand the prospects and
risks of investment strategies. Finally, although Keating identified a potential investment
opportunity to generate significant profits by buying CDS on MBS backed by subprime
mortgages from California where the housing market was severely stressed, he is worried
about his reputation if this strategy goes wrong because of not properly understanding the risks
of the proposed transaction. For instance, even though his prediction about California housing
market is correct, Keating would get nothing if the CDS seller defaults (i.e., counterparty risk).

Page | 3
Now, he must decide whether to invest in the CDS on MBS and if yes, how to structure the
trade.

3. Securitization of home mortgages

Since Keating is planning to bet against the housing market through buying CDS on MBS, he
needs to know the details of the securitisation process of MBS based on home mortgages. The
securitisation process first begins with lenders, usually banks, originating a mortgage loan to a
borrower. Once originated, the banks then package these mortgage loans and sell them to a
securitiser or issuer, also known as Special Purpose Vehicles (SPV). The SPV creates
securities (i.e. Mortgage Backed Securities (MBS) or Collateralised Debt Obligations (CDO) in
general) backed by a pool of similar mortgages. The SPV then categorises those securities into
different tranches (i.e., senior, mezzanine and equity) and hires credit rating agencies to assess
the credit ratings of these securities. With the help of underwriters, these tranches are usually
sold to the investors in the public stock markets whereby the investors are promised interest
payments as well as a principal at maturity. The SPV also contracts a servicing company that
collects interest and principal payments from the homeowners and distributes them to the
investors in the securities, in exchange of a servicing fee. Furthermore, credit enhancement can
be obtained in terms of excess interest, overcollateralization, subordination etc. The whole
securitisation process of MBS is illustrated in Appendix-1.

To address the underlying default risk in the home mortgage pool, MBS tranches are
prioritized sequentially. The cash flows from the mortgage pool are distributed to different
tranches MBS following a waterfall structure. That is, the cash flows are first allocated to
senior tranches followed by mezzanine and equity tranches. However, losses accruing in the
underlying mortgage pool are borne in the opposite direction. Consequently, senior tranches
offer greater credit protection and normally earn a AAA rating from the rating agencies.
Contrarily, mezzanine and equity tranches mostly concentrate the pool’s default risk reflected
by lower or no credit rating, but investors in those securities receive higher coupon rates as
compensation.

4. Subprime mortgage and the Global Financial Crisis (GFC)

As Keating’s proposed trading strategy involves buying CDS on MBS backed by a pool of
subprime mortgages, it is important for him to know about subprime mortgage in details and
how it’s linked to the GFC of 2008-09. Subprime mortgages are the mortgage loans issued to
borrowers with lower credit rating and a higher-than-average default risk and these loans
charge higher interest rates. For instance, a popular subprime mortgage product in 2000s was

Page | 4
NINJA (no income, no job, no asset) mortgage which was too risky (Williams, 2010). Around
71% of mortgage loans were subprime in 2006 ($1.3 trillion), as compared to only 46% in
1996 (Rosen, 2007).

Subprime mortgage is the precipitating factor that triggered the GFC. It all started in early
2000s when the Federal reserve, to tackle the dot-com bubble, lowered interest rate from 6.5%
in 2000 to 1% in 2003 which encouraged mortgage lending (Federal Reserve Board, 2008).
Due to limited supply of creditworthy borrowers and tough competition between mortgage
lenders, mortgage lenders relaxed underwriting standards and originated riskier mortgages to
less creditworthy borrowers (i.e., subprime mortgage). However, the mortgage lenders could
pass these risky mortgages by packaging them and securitising into new financial instruments
(i.e., MBS or CDO, often backed by CDS insurance). As these securities became very popular
among the investors, which consequently accelerated the greed of mortgage lenders to provide
more subprime mortgages (even NINJA loans) without following minimum lending criteria
and then sell them. About 28% of the subprime loans did not meet the minimal standards of
any issuer in 2006-07 and 39% of these below standard loans were subsequently securitized
and sold to investors (Clayton’s Report, 2010). Unfortunately, Lax regulation allowed this
predatory and uncontrolled lending in the financial sector (The 2008 Housing Crisis, 2017).

The problem started when the Fed raised the interest rate to 5.25% in 2006, which caused the
housing bubble burst (Federal Reserve Board, 2008). As prices declined, subprime borrowers
with ARM could not refinance to circumvent the higher payments due to rising interest rates
and started to default. About 14.4% of all US mortgages outstanding were either delinquent or
in foreclosure by 2009 (MBA survey, 2009). The high delinquency rates led to a fast
devaluation of financial instruments (MBS, CDO etc.) which caused liquidity crisis to the
banks who were heavily invested in these assets. The situation got worse when the seller of
CDS like Lehman Brother, AIG, Bear Stearns, Freddie Mac, Fannie Mae and so on
defaulted. Lehman Brothers filed for bankruptcy on September 15, 2008; Freddie Mac and
Fannie Mae were nationalized by the federal government on September 7, 2008 and AIG got
$180 billion as the US federal bailout (Bloomberg, 2008). Eventually, subprime mortgage
problems blowout worldwide since hedge funds and banks around the world had huge
investments in MBS and CDS, thereby leading to a global financial crisis.

5. Credit Default Swap (CDS) and its usage

Keating is planning to buy CDS on MBS to profit from a decline in housing prices as he
expects the housing market in California is going to be severely distressed. However, before

Page | 5
investing in CDS, he needs to know how CDS works and what the usages of CDS are. A CDS
is an insurance-like financial contract between two counterparties where the CDS buyer pays
the CDS seller a periodic fee (i.e., spread) and in return, the seller agrees to make a payment to
the buyer contingent on the default of the underlying financial instrument (i.e., MBS). That’s
why CDS became popular among the MBS investors prior to GFC to mitigate default risk of
the mortgage borrowers. The outstanding credit default swaps value was $62.2 trillion in 2007
(International Swaps and Derivatives Association, 2012).

Investors can use CDS mainly for two reasons- hedging and speculation. Hedging involves
having a direct exposure to the insured risk, that is the investor owns an MBS and then buys a
CDS as a protection against default risk. However, unlike insurance or hedging, the buyer of
CDS does not need to own the underlying MBS, which allows buyers of CDS to speculate on
the performance of the bond issuer. This type of CDS is also known as ‘naked CDS’ or
‘synthetic CDO’. The CDS trade Keating is planning to implement will be a speculation with
naked CDS because he will buy CDS without investing directly in the MBS. As per his
expectation, if the mortgage borrowers default, the MBS would be worth nothing and he will
receive the full notional value of the CDS contract, thus generating significant profits for his
clients.

Furthermore, even if the issuer of MBS does not default, CDS participants can generate
speculative profit from the deterioration of the credit quality of the reference security. If
Keating buys a CDS on the MBS at 3% spread now and one year later the CDS spread rises to
7% due to more market participants’ pessimistic expectation about the same MBS, he could
then sell CDS protection on the MBS at 7% spread while maintaining his long position in the
swap at 3% spread and thus pocketing a profit of 4% spread. In addition, investors can
effectively switch sides on a CDS to which they are already a party. For instance, if a CDS
seller believes that the borrower will default, the CDS seller can purchase its own CDS from
another institution to offset the risks.
5.1 A real-world example of CDS speculation in Greek crisis
During the European Sovereign Debt crisis in 2011, Greece government bonds had a 94%
probability of default. Many investors used CDS to speculate on the probability that Greece
would default. Investors would have to pay $5.7 million upfront and $100,000 per year for a
CDS protection to insure $10 million worth of Greek bonds for five years (Investopedia, 2019).

Page | 6
6. Risks and Rewards of CDS trade
An important financial strategy that capitalizes on the defaults on subprime mortgage is CDS
trade, with or without owning the underlying MBS. Since Keating is thinking of investing in
CDS without owning the subprime MBS, he needs to carefully understand the risks and
rewards of the CDS trade. Apart from the prepayment risks, the most important risk in MBS is
the default risk of the subprime mortgage borrowers. However, CDS doesn’t eliminate default
risk, rather shifts the risk from the mortgage borrowers to the CDS seller. Since CDS is traded
over the counter, the parties of CDS contract also have ‘counterparty risk’, that is, the CDS
seller defaults at the same time the borrower defaults. It was one of the prime causes of the
GFC. CDS sellers like Lehman Brothers, Bear Stearns and AIG defaulted on their CDS
obligations (Bloomberg, 2008). Furthermore, since there is no limit on buying or selling CDS,
outstanding notional amount of CDS could be much higher than face value of MBS, which
could also accelerate the default of the CDS seller if mortgage borrowers default. Therefore, he
needs to buy CDS from creditworthy CDS sellers to minimize counterparty risks.

Contrarily, Keating could generate speculative profits by buying the CDS. If borrowers default
as expected, the MBS would eventually be worth nothing and his clients would receive the full
value of the CDS contract. The return on this CDS trade would be significantly higher since the
notional value received after default would be much higher than the premium paid by his
clients on the CDS contract. Furthermore, even if the borrowers don’t default, Keating could
generate speculative profits from the further deterioration of the credit quality of the MBS. For
instance, after buying a CDS, if Keating finds that the CDS spread rises significantly, he could
then sell CDS protection on the MBS at higher spread and thus pocket the difference in spread.

7. Quantitative modelling for estimating Keating’s profits from the CDS trade on MBS
We have estimated the rate of return Keating could potentially earn from buying the CDS on
MBS, issued by the Structured Assets Securities Corporation, mostly backed by subprime
mortgages in California. The deal had three senior (A1-A3), six mezzanine (M1-M6) and one
junior (B) securities (Exhibit 10). About 41% of the remaining $36.5 million of mortgage
balances were associated with loans going through foreclosure or were more than 90 days
delinquent on their payment (Exhibit 12). Therefore, substantial losses on mezzanine bonds
were inevitable, specially the M6 bond since it will face principal write-downs after junior
security. Therefore, Keating should buy CDS on M6 bond to get maximum profits. We have
estimated that Keating could earn an annualized return of about 258% on this CDS trade,
which is substantial in the time of GFC. (See Appendix-2 for detailed calculations.)

Page | 7
8. Recommendation and Conclusion
We recommend that Keating should invest in the CDS on mezzanine bond M6 because if
mortgage borrowers in California default as expected, M6 will be worth nothing and Keating’s
clients would get the whole notional value of the CDS contract leading to an estimated
annualized return of 258%. This CDS trade would retain Keating’s reputation as a successful
and innovative investment manager. However, he should buy the CDS contract from
creditworthy CDS sellers to minimize the counterparty risks.

References

Bloomberg (November 6, 2008). "Bloomberg-Credit Swap Disclosure Obscures True

Financial Risk". Retrieved August 8, 2019.

Clayton’s Report (2010). "All Clayton Trending Reports 1st quarter 2006 – 2nd quarter 2007".
Retrieved August 82019.

Federal Reserve Board (2008). "Federal Reserve Board: Monetary Policy and Open Market
Operations". Retrieved August 8, 2019.

International Swaps and Derivatives Association (ISDA) (2012). Credit Default Swaps.

Retrieved August 8, 2019.

Investopedia (2019). Credit Default Swaps.

https://www.investopedia.com/terms/c/creditdefaultswap.asp

MBA Survey (2009). "MBA Survey-Q3 2009". Mbaa.org. Retrieved August 8, 2019.

“The 2008 Housing Crisis" (2017). americanprogress.org. Retrieved August 8, 2019.

Rosen, R. (2007). The role of securitization in mortgage lending. Chicago Fed Letter, (244).

Williams, M. (2010). Uncontrolled Risk. McGraw-Hill Education. p. 124. 

Page | 8
Appendices

Appendix-1: The securitization process of MBS

Page | 9
 Source: Technical content provided by the lecturer

Appendix-2: Quantitative modelling for estimating Keating’s profits from the CDS trade

Mortgage Pool Assumptions

·       Mortgage pool receives 6% principal in prepayments each month (Exhibit 2 and 13)

Page | 10
·       Principal write-downs of 10% per month associated with earlier defaults. (Logical
reasoning: Principal write-down in September was $372519, which was 6.54% of the original
balance of M6 bond (Exhibit 13) and as Keating expects, it's highly likely to increase in the
following months because an astounding 41% of the remaining $36.5 million of mortgage
balances were associated with loans going through foreclosure or were more than 90 days
delinquent on their payment (Exhibit 12). Therefore, substantial losses on mezzanine bonds
were inevitable. So, we assumed a higher write-downs from 6.54% to 10%.)
MBS Assumptions
·       MBS consists of mezzanine securities M2 to M6 and a junior security B
·       Face value of M6 = $100 each; face value of B = $30 (Logical reasoning: Original value
of M6 is about 3.4 times higher than that of B bond (Exhibit 13))
CDS Assumptions
·       One-year CDS with reference bonds M6 (We chose M6 because it will get hurt due to
principal write-downs after junior bond B and thus will generate higher profits in CDS trade)
·       Original notional value of swap transaction = $300 (IRR remains unchanged irrespective
of notional value)
·       Swap spread for M6 bond = 95.25% (Exhibit 15)
Principal Outstanding Notional Fixed Swap Floating Rate
Net Cash Flow to
  Writedown Face Value Size of Payment by Payment by
CDS Buyer
on Bond a on Bond b Swap c CDS buyer CDS seller
Month ($) ($) ($) ($) ($) ($)
0   100 300.00      
1 0 94 282.00 23.81 d 0.00 -23.81
2 0 88 280.85 22.38 0.00 -22.38
3 0 82 279.55 22.29 0.00 -22.29
4 10 66 241.46 22.19 34.09 e 11.90
5 10 50 227.27 19.17 36.59 17.42
6 10 34 204.00 18.04 45.45 27.41
7 10 18 158.82 16.19 60.00 43.81
8 10 2 33.33 12.61 88.24 75.63
9 0 0 0.00 2.65 0.00 -2.65
10            
11            
12            
      Annualized IRR of CDS buyer 258%
Source: Group members’ calculation
a
Junior bond B suffers principal losses in Month 1 to 3. Losses on Mezzanine Bond M6 occur from month 4 once
Bond B has been completely written off.
b
Principal payments and write-downs reduce outstanding face value.
c
The notional size of swap adjusts in proportion to the change in face value of the underlying bond. For example,
notional size of swap in month 1 is $282 = (94/100)*300
d
The fixed payment based on the previous month’s notional size of swap. For example, fixed swap payment by in
month 1 is $23.81 = (95.25% / 12) * $300.
e
The floating payment based on the fraction of the previous month’s bond face value that has been written down.
For example, floating payment in month 4 is $34.09 = ($10 / $82) * $279.55

Page | 11